lawsuit settlement after business sold

Taxpayer sold his business (s corp) in an installment sale in 2016. After the sale employees of the business brought a lawsuit against the corporation for back wages and overtime. Both he and the new owners were named in the lawsuit. The case was recently settled and the employees were awarded a significant amount of back wages with $250,000 being assessed against my client. Not sure how this is deducted on his return. Would it be an ordinary business loss on 4797? Hopefully not a capital loss on Schedule D? Does it impact on the proceeds from the installment sale? Appreciate any clarity.

I think you look to origin of the claim. If he were still operating the business, back wages would be a 162 expense. But he sold the business, and had the liability been identified, he would have received less for his stock - reducing gain or increasing loss. I think you have a capital loss.

Hopefully others will chime in with corrections or cites. I don't have the latter at my fingertips.

I'm wondering if his basis can be increased for the installment sale due to the new obligations he is incurring and the profit % be reduced.

Ordinary deduction because the wages at issue would have been an ordinary deduction to the S corp.

The origin of the claim test does not require a mechanical tracing of cause and effect. It's a qualitative analysis of the underlying obligation. If that obligation is one to pay wages, it seems the payment in settlement, by whoever makes it, gives rise to an ordinary deduction.

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372 F.Supp.2d 1265
The Supreme Court has developed the “origin of the claim” test to determine whether litigation expenses may be deductible as business expenses. See United States v. Gilmore, 372 U.S. 39, 83 S.Ct. 623, 9 L.Ed.2d 570 (1963). Under the origin of the claim test, it is the origin and character of the claim for which litigation expenses are incurred, rather than the potential consequences upon the fortunes of the taxpayer, which determines whether an expense was “business” or “personal,” and hence, whether it is deductible under Section 162 or Section 212. The “origin of the claim” test does not contemplate a mechanical search for the first in the chain of events which led to the litigation but, rather, requires an examination of all of the facts, including the kind of transaction out of which the litigation arose, the issues involved, the defenses raised, and other facts pertaining to the controversy which led to the lawsuit. Peters, Gamm, West & Vincent, Inc. v. Commissioner of Internal Revenue, 1996 WL 182545 (U.S.Tax Ct.1996). See also Kopp's Company v. United States, 636 F.2d 59 (4th Cir.1980);17 Burch v. United States, 698 F.2d 575, 577 (2nd Cir.1983). In applying the origin of the claim test, the proper focus is not upon the potential consequence of the litigation, but rather upon the origin and character of the controversy which led to the expenses. Barr v. Commissioner of Internal Revenue, 1989 WL 90207 (U.S.Tax Ct.1989).18 See also Walsh v. *1276 United States, 1977 WL 4336 (N.D.Tex.1977) (Fiduciary could deduct legal fees on income tax return as a cost of conserving the trust; although title perfection or defense was involved in the underlying litigation, the “primary purpose” of the litigation was administrative in nature).

When the Dept of Labor brings a claim for violation of the Fair Labor Standards Act - they add triple damages as a Penalty - what if 2/3rds of the $250,000 is actually Penalty?

A quick scan of this article could indicate 162 treatment. http://www.woodllp.com/Publications/Art ... 090201.htm The discussion under "most recent mess" discusses the tax treatment from the other side - there were sales in the facts of the cases, but receipts were ordinary income, not tied to the sale.

Perhaps that will give you a starting point for your research? For $250,000, you can't wing it.

I also agree that you need to take a look at the impact on your installment sale, but I'm guessing there is no impact. If you claim a 162 deduction for $250,000, what would have been a decrease in basis is offset by the increase in basis related to what would have been a capital contribution to make the payment?

Sorry I am not more helpful, but at least I helped you get a discussion going...

This was a stock sale, is that right?

I’d bet the purchase/sale document has a section in there about representations, indemnifications, warranties, etc. that cover undisclosed liabilities. If that section is invoked, this is really a purchase price adjustment.

When the Dept of Labor brings a claim for violation of the Fair Labor Standards Act - they add triple damages as a Penalty - what if 2/3rds of the $250,000 is actually Penalty?

Employees brought the case not the Feds. The answer would be different if we were dealing with an underlying penalty claim.
Installment sale seems irrelevant to the analysis.
Bob Woods article is also not on point given that he's addressing proceeds not payments.
Jeff, we're dealing with the seller here. How would the SPA adjust the seller's consideration on account of the fact that the seller is out of pocket $250K? In a standard SPA, buyer indemnifies for breach of buyer reps. But, none of the standard buyer reps go to this issue. (Buyer reps that he has authority to buy, has funds, etc.). Buyer has not breached any reps. I would say, the issue of SPA reps, warranties and indemnities is also irrelevant to the analysis...unless I'm missing something.

Given the number of opposing viewpoints, I would put a memo in the file that supports the tax return position ultimately taken.

This was a stock sale. The original agreement was for $1,200,000. In 2018 there was a settlement agreement which reduced the purchase price to $480,000. This was in settlement of an action the new owner brought against the seller (my client) for breach of contract. In reading the settlement contract it discusses that the parties are co-defendants in a separate action filed by former employees for unpaid overtime. As a material term of the Settlement agreement the Defendant (my client) agreed that he shall be personally liable for 75% of any final judgement attributable to the period of time he was a 75% owner of the company (he sold his shares to the former 25% owner). The installment sale purchase price was adjusted in 2018 to $480,000.

So how i am interpreting this is that the purchase price was reduced for disputes other than the employment action since my client agreed to be personally liable for his share of the final judgement on the wage dispute.

I don't have the original agree only the settlement agreement. On these set of facts does it appear to be a purchase price agreement? I was thinking it would be a basis adjustment but as JAD pointed out it would be a reduction in basis for the additional expense and an increase in basis for his capital contribution which wipe out each other.

Jeff, we're dealing with the seller here.

How would the SPA adjust the seller's consideration on account of the fact that the seller is out of pocket $250K?

It would reduce the seller’s amount realized.

Given the number of opposing viewpoints, I would put a memo in the file that supports the tax return position ultimately taken.

There’s only one right answer here. OP hasn’t given us a whole lot of facts. She makes comments like “taxpayer sold his business,” which is nebulous. Then she talks about “new owners” – new owners of what – the stock or the assets? And then she talks about the assessment being against “her client” and uses phrases like “his return,” implying a 1040. My best guess was this was a stock sale, which she confirmed.

Buyer has not breached any reps.

I didn’t say the buyer breached any reps, nor did I say the seller did. What I’m suggesting is that as part of the agreement, the seller may have indemnified the buyer against unknown liabilities that existed at the time “the business” was sold. Hence the seller “being on the hook” for this obligation for that reason. That would be the origin of the claim. This is why we have escrow agreements and so forth.

If the assets were sold, then seller S-corp still existed, after the sale, as an entity owned by Theresa’s individual client. That issue needs to be resolved. If that’s the case, and if assets were sold, then the claim may not have arisen from any indemnification provision. Rather, it’s as you suggest – a claim directly against Oldco by former Oldco employees.

Finally, the actual details of the case are a bit unclear. Don’t know when the suit arose and if all aspects of it pertained to the time prior to the business being sold.

You are saying that you want to take the position that the client's payment essentially reduces the (net) sales proceeds received? In that case, I think you are trying to treat the installment sale as having a contingent price. Perhaps this will get you started. If it were me, I would want some case law or other authority with similar facts to back up my treatment.

https://www.ipbtax.com/media/news/190_0 ... _30_12.pdf

What I’m suggesting is that as part of the agreement, the seller may have indemnified the buyer against unknown liabilities that existed at the time “the business” was sold. Hence the seller “being on the hook” for this obligation for that reason. That would be the origin of the claim.

Yeah, except that's not what OP originally presented. She said employees sued the ex-owner of an S corp. She essentially told us in #1 that it was (i) a stock deal and (ii) that seller is going to be personally out of pocket $250K.

OP now reveals more facts, but in essence the seller is still liable to the employees for wages, not to the buyer under the SPA.

There’s only one right answer here.

Probably. But, if you poll the commentators here, it's not coming out that way. My gut says the $250K is deductible as ordinary expense when paid by seller.

Are we arguing over something that ultimately matters? The purchase price adjustment will reduces cap gains at 20 percent. What's the rate at which ordinary expenses are tax effected for this seller?

His capital gains rate is 15%. He is in the 22% ordinary income rate. However if it's an adjustment to the purchase price that reduction in the capital gains he realizes will be spread over the installment loan period (10 YR). Whereas an ordinary loss taken in 2019 for the $250000 will result in an NOL this year.

She said employees sued the ex-owner of an S corp.

No, she didn’t. She said:

After the sale employees of the business brought a lawsuit against the corporation

She said the suit was “against the corporation.” If the suit was “against the corporation,” then the corporation would be liable, clearly (but maybe not solely liable).

It’s pretty telling that the corporation didn’t end up paying anything, other than maybe the 25%. Is that because the corporation was indemnified? I don’t know, maybe…

I will also submit, which I have already stated, the OP did a poor job of naming names/spelling out the facts. In one sentence she says “a lawsuit against the corporation.” In the very next sentence, she says, “Both he and new owners were named in the lawsuit.” What the hell does this mean? A corporation is not a “he.” It is an it. If OP is stating that the corporation was sued, the individual former shareholder was sued and the new individual shareholder(s) was sued, she should make that clear. And she should also tell us why. Might be that the suit as to the individual shareholders is meritless (i.e. corporate veil, which is why people incorporate), but then again, maybe not if something like the FLSA is involved.

OP now reveals more facts, but in essence the seller is still liable to the employees for wages, not to the buyer under the SPA.

We really don’t know if the individual seller would really liable to the EE’s or not. Suit could be entirely meritless as to the individual shareholders, as stated. But if we play along, we’d also say the corporation is “still liable” as well. Seems that under your theory, the suit could get settled as to the individual shareholders, but then proceed against the corporation. Sure seems to me that the corporation will be let off the hook once things shake out.

Are we arguing over something that ultimately matters?

Maybe…if the IRS denies your ordinary, above-the line deduction (an above the line deduction I think is what you’re suggesting) and then tells you that 2% deductions went away a few years ago…I mean, if your argument is that the former shareholder/employee has clear-cut personal liability to the EE’s and is paying the expense because of that, and not because of any indemnification obligation stemming from the sale of his stock, seems the IRS would have a pretty good argument…

In any event, just go back to your Post #4, where you said:

The “origin of the claim” test does not contemplate a mechanical search for the first in the chain of events which led to the litigation but, rather, requires an examination of all of the facts, including the kind of transaction out of which the litigation arose, the issues involved, the defenses raised, and other facts pertaining to the controversy which led to the lawsuit.

…and then look at some of my comments, namely about how OP is giving us everything we need to know here. And then go back to my Post #7, which is related to that idea, where it is surmised that the purchase agreement might have an indemnification clause as to undisclosed liabilities. That is a possibility that cannot be ignored. Very often, when an indemnification clause is invoked, there’s no litigation surrounding it. If both parties agree that the seller is liable pursuant to that agreement, then so it is. In this case, it could very well be that because of an indemnification clause, the seller and the buyer agreed that the seller is liable (for 75%) and the payment in question isn’t being made because of purported personal liability on the seller’s end to the EE’s, but rather, because of liability running to the buyer/corporation because of the indemnification agreement. You see, even if the individual seller might be personally liable to the EE’s under something like the FLSA, he would still be liable (to the buyer) if there is an indemnification agreement. So, from a financial standpoint, the seller might not care who he’s liable to – the EE’s or the buyer – if he’s definitely liable to at least one.

and (ii) that seller is going to be personally out of pocket $250K.

I don’t see why that matters. He’d be personally out of pocket under an indemnification agreement all the same…even if buyer (or corporation) paid it and then said, “I’m going to pay you $250k less on the installment note.”

Probably. But, if you poll the commentators here, it's not coming out that way.

Yeah, well. I don’t think a judge is going to say, “I’m not sure.” A judge will get to the facts, which is all I’m trying to do here. And then the judge will render a decision. Theresa can pull the agreement and let us know if there’s an indemnification clause or not.

I am sorry that I was not clear in my OP and subsequent comments. I did post any answer previously but somehow it never posted. To clear up the facts as I know them:
My client was a 75% shareholder in an S corp. In 2017 he sold his shares to the 25% shareholder in an installment sale under a stock purchase agreement. I was not the accountant at that time. In January 2018 the 100% shareholder (plaintiff) commenced an action against my client (defendant) alleging breech of the stock purchase agreement. In settlement of this claim a settlement agreement was signed in 2018 and the purchase price of the stock was adjusted to $480,000 from 1,200,000. I prepared my client's 2018 1040 and the gross profit percentage on Form 6252 was adjusted due to the revised purchase price.
The settlement agreement dated in 2018 contains a clause that the parties of the settlement agreement are co-defendants in a separate action filed by former employees of the company seeking, inter alia, unpaid overtime wages . As a material term of this settlement agreement the defendant (my client) agreed that he shall be personally liable for 75% of any final judgement or settlement of this action attributable to the period of time he was a 75% owner(shareholder) of the corp. He would not be liable for any judgement amount applicable to the period after he had sold his shares.

The judgement was issued in 2019 and his liability under the settlement agreement was $250,000 which he paid in 2019.
I hope this adds some clarity to what transpired and appreciate everyone who has taken the time to comment.

I hope this adds some clarity to what transpired and appreciate everyone who has taken the time to comment.

No, it doesn’t. I was wondering about the original agreement. (At first you said it was 2016, now you say it was 2017…)

That was a mistype on my part . Sale occurred in 2017. No indemnification clause in original agreement.

What I’m suggesting is that as part of the agreement, the seller may have indemnified the buyer against unknown liabilities that existed at the time “the business” was sold. Hence the seller “being on the hook” for this obligation for that reason. That would be the origin of the claim.

Yeah, except that's not what OP originally presented. She said employees sued the ex-owner of an S corp. She essentially told us in #1 that it was (i) a stock deal and (ii) that seller is going to be personally out of pocket $250K.

OP now reveals more facts, but in essence the seller is still liable to the employees for wages, not to the buyer under the SPA.

There’s only one right answer here.

Probably. But, if you poll the commentators here, it's not coming out that way. My gut says the $250K is deductible as ordinary expense when paid by seller.

Are we arguing over something that ultimately matters? The purchase price adjustment will reduces cap gains at 20 percent. What's the rate at which ordinary expenses are tax effected for this seller?

Ok - Ordinary Expense (IRC Sec 162 - Business Expense) paid in 2019 (according to OP) where do you advise OP to deduct this "Ordinary Expense" - where - what form?

Reading #1 and #15, there is a lot of consistency in the facts presented on the material issue. We knew from post #1 that the shareholder was sued by employees. Jeff, I know you've said otherwise, but when #1 states that the shareholder was "named in the lawsuit" it means he was sued. Yes, the corporation was sued. But so was the shareholder.

where do you advise OP to deduct this "Ordinary Expense" - where - what form?

So, if the right answer is that this is an ordinary expense, how do you report it? Or, is the point that since the reporting is not immediately clear, it casts doubt on the deductibility?

Re whether the position taken, "matters," if you look at present values, it may be close. The PV of $250K over ten years at, say, 5% is a benefit of $29K. The PV of a deduction spread over two or three years to a taxpayer in the 22% tax bracket might not be significantly higher because the taxpayer's effective rate could be much lower.

No indemnification clause in original agreement.

Ok, thanks. That’s all I wasking in Post #7. Anytime you have a sale and then seller later ends up on the hook for something, it is a facet we need to know about. I’ll take your word for it. Surely there were some representations, warranties, etc., but if so, you’re saying none of them would cover the issue at hand. I have my doubts this was some kind of handshake deal, given the original selling price.

Ok - Ordinary Expense (IRC Sec 162 - Business Expense) paid in 2019 (according to OP) where do you advise OP to deduct this "Ordinary Expense" - where - what form?

Great question. I asked the same thing…

Reading #1 and #15, there is a lot of consistency in the facts presented on the material issue.

There was a material omission, as much as you’d like to deny it. It was simply postulated, way back in Post #7, that an indemnification agreement might be at play. Those are very common when a stock sale has occurred and for obvious reasons (especially when we’re talking about a $1m+ deal). That is an important facet to this analysis.

Jeff, I know you've said otherwise, but when #1 states that the shareholder was "named in the lawsuit" it means he was sued.

No, that’s not what it said. It said “Both he and the new owners were named on the lawsuit.” What does “both he” mean? Well, let’s look to the preceding sentence:

After the sale employees of the business brought a lawsuit against the corporation for back wages and overtime.

Sounds like she’s referring to the corporation as a “he.” And if she’s referring back to the original sentence, about how the “taxpayer sold his business” we are left to guess if stock was sold or if assets are sold.

In a nutshell, she’s asking us to opine on a big dollar amount, but gives us unclear and muddy facts.

…In any event, if we agree that the former shareholder was sued, why the former shareholder might be personally liable was never mentioned. Was the suit frivolous/meritless as to the former shareholder, personally? Don’t know. No information was provided. If it was meritless, that’s important…especially if there was an indemnification agreement. That would imply that the former shareholder was settling not because of the personal suit from the EE’s, but because of the indemnification agreement.

Quite honestly, I don’t even see how anyone could opine on this situation without first knowing if there was an indemnification agreement…and without knowing all the nitty gritty details. I still don’t know if the personal suit against the former shareholder has any legs to it or not…

Yes, the corporation was sued. But so was the shareholder.

Then you tell us: Was this just some personal obligation the former shareholder ended up paying since he was personally sued?